Delusion and Investment Behavior
I read a Scientific American article recently about lying and its importance to human survival. I have added some comments below on this article. See the link below.
Self-Deception and Lying
Psychological research (Trivers) shows that humans developed ways to delude themselves in order to lie better. It turns out that non-verbal clues usually give the lying subject away such as nervous ticks, feet shuffling, eyes averting, etc. In order to avoid these giveaways, the individual must believe the lie himself. Those individuals who were better at lying had improved chances of survival by garnering more resources and superior social relationships.
Contemporary studies reveal high school and college students who are better at deceiving their peers also perform better socially and economically. As we all know, the best politicians like Bill Clinton, for example, are good liars. Even after they are discovered lying, people still like them.
Scientific
American Mind June 2005 "Natural-Born
Liars"
Why
do we lie, and why are we so good at it? Because it works
http://www.sciammind.com/print_version.cfm?articleID=0007B7A0-49D6-128A-89D683414B7F0000
Investment Behaviour
What does this have to do with investors? This self-delusion ability bestowed by evolution turns out to be a tremendous handicap to the long term investor.
People delude themselves in seven ways even though they know facts to be otherwise:
A) The market will go up forever...
OR
B) Blind trend-following…I want to follow
everyone as they must know something I don’t.
Given small tribe situations, humans evolved to follow the crowd as many heads are better than one. In a complex world, this behavior can lead to unnecessary excesses.
C) Ignoring painful losses that they choose to hide statements and the like...
Losses produce twice the response (negative) of a win (positive). I call it the "deer in the headlight syndrome."
Regret falls under a psychological effect known as loss aversion. Research shows that before we risk an investment, we need to feel assured that the potential gain is twice what the possible loss might be because a loss feels twice as bad as a gain feels good. That's weird and irrational, but it's the way it is.
Holding periods for stocks in a bull market are 9 mo to 1 year. In a bear market, average holding periods can rise to 10 years.
Same idea applies to real estate. People hold for a long time rather than taking a loss. It's the forced sellers though that set the price.
Average holding time for a traded instrument is like a bathtub. At the beginning, people hold on until prices start to move. Then they trade the item more and more until the bubble bursts. Losses are so painful, people avoid them, and average holding times rise. This behavior explains hoarding and reduced economic activity after a bubble bursts.
Also...
D) I'm smarter than everyone else. Only I am benefiting from the rise.
E) My neighbor will get
one up on me.
F) Stingy when you're down, generous when you're up.
From Virus of the Mind p130:
'The survival instinct to conserve scarce resources and be more lavish when resources are abundant is the exact opposite of the optimal money-management strategy. Computer modeling shows you will go the longest if you bet more when you're behind, less when you're ahead.'
In other words the richer you are the more conservative and safer you should be!
These handicaps result in most investors underperforming. In fact to be in the top 20%, investors need to simply avoid buying the most popular funds/stocks. People are buying these investments when they are at a top, or they hold on all the way down.
G) Focusing on noise or
law of small numbers.
People make the mistake of overstating the importance of small samples (in many cases one observation, “the market did so and so today”.)
As bull markets run, I have realized the extent of the delusion also increases. Initially, prices are below the fundamental value. As time wears on, people get carried away and can't believe it will ever end. It's similar to Minsky instability where the longer a trend runs the more unstable the financial arrangements become at the end. I have created a chart illustrating this concept.
This process is related to Minsky instability: the longer a given condition or trend persists, the more dramatic the correction when the trend fails. I also add the concept of magnitude.
Magnitude is reflected in price changes. I use a 45 week change which is useful at the 'ends' of a trend. Positive changes for a bull and negative changes for a bear.
Delusion Gap
